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Retirement accounts are protected from creditors in bankruptcy cases so people don't wind up destitute in old age. However, the court unanimously ruled on Thursday that this is not the case for those who inherit IRAs.
The court decision involves a case of a woman who inherited about $450,000 in an IRA from her mother in 2001 and started taking distributions from the account. In 2010 the woman and her husband filed for bankruptcy and sought to keep the remaining $300,000 out of the hands of creditors, arguing the IRA money was protected "retirement funds." The bankruptcy court disagreed, and subsequent court decisions went back and forth.
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Supreme Court justices said there were three reasons why inherited IRAs are not retirement funds, which are "properly understood to mean sums of money set aside for the day an individual stops working."
Unlike the original owner of the IRA, heirs can't add money to the account, the court said.
Heirs also can take out all the money at once - at any time and for any reason - without paying a 10 percent penalty for withdrawals before age 59½, the court said. If heirs were allowed to exempt this money from creditors, for instance, they could use the entire balance to buy a vacation home or sports car once they exited bankruptcy, the justices explained.
And heirs are required to start taking distributions in the year after the death - no matter how many years they are from retirement.
"A 2-year-old would have to take a distribution at age 3. That's not retirement," says Ed Slott, a certified public account and IRA expert.
The court's decision doesn't affect IRAs inherited by spouses, who can always roll over the account to their own IRA, Slott says.
Parents worried that their IRA might someday end up in the hands of their heirs' creditors have a few options.
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Several states specifically protect inherited IRAs from creditors, and families should find out if their state is one of them, Slott advises. In fact, the Supreme Court ruling may prompt more states to shelter inherited IRAs, he says.
Otherwise, children will need to be forewarned that if they file for bankruptcy in the future, their creditors can go after an inherited IRA, he says.
Parents can also protect an IRA from creditors by setting up a trust and naming it as the IRA beneficiary, instead of the child, Slott says. But he cautions: "It's involved. It's costly."
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